Rationality in economics has traditionally been depicted as a linear pathway leading to a single, optimal decision point, guided by the assumption that all agents behave in predictably rational ways. This view, deeply rooted in neoclassical economic theory as shaped by luminaries like Paul Samuelson, posits that with the right information, everyone would arrive at the same conclusion. However, everyday decisions—from choosing a breakfast cereal to making significant financial investments—often demonstrate that individuals operate under a variety of influences that can lead to different outcomes.
Consider the simple decision of buying a car. A young professional might initially prefer a stylish, compact sports car, valuing its aesthetics and performance. Meanwhile, another individual may prioritize practicality, opting for a reliable and fuel-efficient vehicle that ensures they can commute safely to work and back every day. As life circumstances change—perhaps with the arrival of children—the first individual's preferences might shift towards a spacious, safety-oriented family vehicle. These examples underscore how rationality is not only dynamic but also deeply personal, molded by individual circumstances, needs, and evolving life stages.
This diversity in preferences illustrates the impracticality of assuming a single rational answer. It also highlights that changes in individual preferences over time do not converge to a single point but rather demonstrate that diverse rationality persists over time and across different contexts. When policies are crafted based on a presumed uniform rationality, they often fail to account for the diverse needs and changing circumstances of the population, leading to outcomes that are more harmful than helpful. This realization calls for a broader understanding of rationality as a spectrum of decision-making that is intensely personal and variable throughout our lives.
Embracing Diverse Rationality is essential for human flourishing.
About the author: Jeff Hulett leads Personal Finance Reimagined, a decision-making and financial education platform. He teaches personal finance at James Madison University and provides personal finance seminars. Check out his book -- Making Choices, Making Money: Your Guide to Making Confident Financial Decisions.
Jeff is a career banker, data scientist, behavioral economist, and choice architect. Jeff has held banking and consulting leadership roles at Wells Fargo, Citibank, KPMG, and IBM.
The Traditional View of Rationality
The traditional economic model of rationality, often called "robo-rationality," is predicated on the notion that individuals make decisions by maximizing utility based on a stable set of preferences and perfect information. This model has dominated economic theory since the mid-20th century, significantly influenced by Paul Samuelson. Samuelson's framework, which mathematized economics, required simplifying human behavior to mathematical equations, assuming that all economic agents act identically under similar circumstances.
The Misalignment of Neoclassical Economics
While elegant in theory, the neoclassical approach often fails to capture the complexity and richness of human behavior. It overlooks how different contexts, personal histories, and even changes in mood can dramatically influence decision-making. This oversimplification has led to policy missteps and economic models that are often disconnected from real-world behaviors. To be clear, Samuelson's approach has merit and is useful in certain circumstances. But like any tool, it is prone to misuse in the wrong application.
Adam Smith’s Invisible Hand and Moral Sentiments
Long before behavioral economics became a formal discipline, Adam Smith, in his seminal works "The Theory of Moral Sentiments" and "The Wealth of Nations," proposed theories that embraced the complexity of human motives. Smith introduced the concept of the "invisible hand," suggesting that individual self-interest, tempered by moral considerations and social interactions, leads to outcomes that are beneficial for society as a whole.
Smith’s understanding of rationality was not limited to economic transactions; it encompassed a broader spectrum of human behavior, including sympathy and the desire to be both loved and lovely, which he argued were fundamental to human interactions. Unlike his neoclassical successors, Smith recognized that rationality was variable and personal—shaped by an individual's experiences, social norms, and moral judgments.
Herbert Simon’s Bounded Rationality
Herbert Simon challenged the notion of perfect rationality with his concept of "bounded rationality," introduced in the 1950s. Simon argued that decision-making is limited by the information available, the cognitive limitations of the mind, and the time available to make the decision. This theory was a pivotal shift away from the idea of an all-knowing, always rational economic agent, proposing instead that humans are "satisficers" who seek solutions that are good enough, rather than optimal.
F.A. Hayek and the Limits of Knowledge
F.A. Hayek’s work, particularly his Nobel lecture "The Pretence of Knowledge," further challenges the traditional views of economic rationality. Hayek criticized the overconfidence of scientific prediction in economics, arguing that such pretense ignores the dispersed nature of information and the complexity of human behavior. His insights support the notion of diverse rationality, emphasizing that economic phenomena emerge unpredictably from the interactions of individuals with unique preferences and knowledge bases.
David Ricardo’s Comparative Advantage
David Ricardo’s theory of comparative advantage provides another historical backbone to the concept of diverse rationality. Ricardo demonstrated that economic success does not require every participant to excel in all areas but to specialize according to their relative strengths. This theory implicitly acknowledges the diversity of capabilities and rationalities among individuals and nations, suggesting that specialization based on diverse rational advantages leads to more efficient outcomes for all involved.
Integrating Diverse Rationality in Modern Economics
The concept of "diverse rationality" builds on the foundations laid by Smith, Simon, Hayek, and Ricardo, acknowledging that rationality encompasses a wide range of decision-making processes influenced by varying factors. This approach views economic agents as diverse individuals influenced by different cultural backgrounds, personal experiences, and emotional states.
Behavioral economics has provided tools for understanding and shaping economic behaviors by acknowledging the imperfections and biases inherent in human decision-making. Richard Thaler’s concept of "nudges" is a prime example. Nudges are subtle policy shifts that guide people’s behaviors in predictable ways without restricting their freedom of choice. For instance, by changing the default settings for retirement savings plans to opt-out rather than opt-in, participation rates increase significantly. This method leverages the human tendency to stick with default options, enhancing savings behavior without mandating participation.
Jeff Hulett has applied principles of behavioral economics to personal finance, emphasizing the need for a consistent, repeatable decision-making process that acknowledges diverse rationalities. His work includes developing tools and seminars that help individuals understand their financial behaviors and make better choices. By integrating behavioral insights into personal finance, Hulett helps people navigate the complexities of financial decision-making, which can vary greatly depending on personal circumstances and life stages.
Complexity economics, spearheaded by thinkers like Doyne Farmer and Rob Axtell, extends the idea of diverse rationality to larger economic systems. Farmer's work involves using data and algorithms to model and predict complex market behaviors. For example, his research into the housing market in Washington, D.C., employs agent-based models to understand how different economic policies might affect housing prices and availability. These models consider a variety of factors, including interest rates, income levels, and demographic changes, offering a nuanced view of how diverse rationalities interact within the market.
During the COVID-19 pandemic, Farmer’s approaches were instrumental in modeling the economic impacts of various public health decisions, demonstrating how small changes in individual behavior could significantly affect the overall economic outcome. By simulating different scenarios, complexity economics provides policymakers with a clearer understanding of potential outcomes, helping them to make decisions that are better aligned with the diverse needs of the population.
Conclusion: Embracing a Broader Definition of Rationality
The redefinition of rationality as a diverse and personal attribute marks a significant evolution in economic thought. It aligns more closely with real-world behaviors and offers a more nuanced framework for understanding economic interactions. By embracing this broader definition, economists and policymakers can design better tools and policies that accommodate the true nature of human decision-making.
This journey through economic thought—from the rigid frameworks of Samuelson to the nuanced perspectives of Smith, Simon, Hayek, and Ricardo—illustrates a critical shift in understanding rationality. It highlights the need for economic models and policies that respect the diversity of human behavior, promoting not only economic efficiency but also fairness and individual well-being. By acknowledging the true complexity of rationality, we can better navigate the challenges of modern economies and societies.
Resources for the Curious
Hulett, Jeff. Making Choices, Making Money: Your Guide to Making Confident Financial Decisions. Paperback, published July 25, 2023.
Hulett, Jeff. Top 6 Reasons Why Personal Finance Success Starts with Choice Architecture. The Curiosity Vine, 2023.
Hulett, Jeff. Becoming Behavioral Economics: The Social Science Revolutionizing Decision-Making. The Curiosity Vine, November 7, 2023.
Hulett, Jeff. Adam Smith and How Choice Architecture Makes the Invisible Hand More Visible. The Curiosity Vine, July 9, 2023.
Smith, Adam. The Wealth of Nations. First published 1776.
Smith, Adam. The Theory of Moral Sentiments. First published 1759.
Simon, Herbert A. Models of Man: Social and Rational. John Wiley & Sons, Inc., Hardcover, 287 pages, first published January 1, 1957; fourth printing July 1966.
Hayek, F.A. The Sensory Order: An Inquiry into the Foundations of Theoretical Psychology. University of Chicago Press, Paperback, 232 pages, June 1, 1999. First published January 1, 1952. ISBN: 9780226320946.
Hayek, F.A. "The Pretence of Knowledge." Nobel Lecture, 1974. Available at: https://www.nobelprize.org/prizes/economic-sciences/1974/hayek/lecture/.
Ricardo, David. Principles of Political Economy and Taxation. First published 1817.
Thaler, Richard H., and Sunstein, Cass R. Nudge: Improving Decisions About Health, Wealth, and Happiness. Penguin Books, Paperback, 260 pages, February 24, 2009. First published April 8, 2008. ISBN: 9780143115267.
Farmer, J. Doyne, and Foley, Duncan. "The Economy Needs Agent-Based Modeling." Nature, Vol. 460, August 6, 2009, pp. 685-686. DOI: 10.1038/460685a.
Kahneman, Daniel, and Tversky, Amos. "Prospect Theory: An Analysis of Decision Under Risk." Econometrica, Vol. 47, No. 2, 263-291, 1979.
Kahneman, Daniel. Thinking, Fast and Slow. Farrar, Straus and Giroux, Hardcover, 499 pages, October 25, 2011. ISBN: 9780374275631.
Roberts, Russell. How Adam Smith Can Change Your Life: An Unexpected Guide to Human Nature and Happiness. Portfolio, Hardcover, 261 pages, October 9, 2014. ISBN: 9781591846840.